Investment Strategy
EYES AND EARS (23/01/2012)	JANUARY 2012

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In our opening piece for the new year, ‘Investment Themes for 2012’, we attempted to highlight some of the potentials problem areas facing investors this year – North Korea (yet to march on Seoul, thankfully), the tense war of wits in the Strait of Hormuz and the Eurozone saga.

At the point of going to print, the latest news on the stand-off between the EU/UK/US and Iran is that the United States, France and Britain sent a flotilla of warships through the Strait in a show of force over the weekend. This was in the face of Iran’s pledge to blockade the Strait to prevent the passage of oil if the EU imposed a ban on Iranian oil exports. In the event, this is precisely what EU foreign ministers have done this afternoon. According to a statement from the EU, its Council has banned imports of Iranian crude oil and petroleum products. The prohibition concerns import, purchase and transport of such products as well as related finance and insurance. They confirm that contracts already concluded can still be executed until July 1 and that a review of the measures relating to oil and petroleum products will take place before May 1.

It now remains for Iran to make some response. Markets are following developments closely and the West Texas Crude Future price has edged back up towards the US$ 100 p.b. level. However, the current supply position, barring conflagration in the Strait, coupled with generally mild winter conditions so far in many markets suggests that the oil price should be lower than it is now.

With regard to the Euro, in many people’s minds, the Eurozone Crisis is simply about whether the Euro survives or not. That is, ‘disintegration’ equates to ‘disappearance’. In fact, there exist many scenarios for the space ‘in-between’ these polar positions. We are supposed to be getting some resolution of the Greece’s position today (it should have come on Friday). A voluntary agreement by bondholders would avoid a default and allow outstanding Greek debt to be cut by around €100 BN and, just to focus their minds, Greece has a bond nominally worth over €14BN due for renewal on 20th March. Negotiations centre on a possible haircut of around 65 %.

The situation for Germany with regard to the Euro, I surmise, is that it suits them to have weaker members in the Eurozone to keep their currency for exports competitive. (However, they are unlikely to admit this cynical line of thinking publicly). This is acceptable as long as it does not cost them too much to keep the Eurozone together in the form of bailout contributions for countries like Greece, Portugal, Ireland and even (God help us !) Italy.

There must come a point where Germany, the strongest member of the Monetary Union, would decide either to leave and readopt the Deutschemark or to remain within the Eurozone but only with stronger members such as Holland and other Northern European members. As long as the implicit support of Germany exists, the Euro is likely to retain support. If people believed that it was about to exit the Euro, the Euro project would look fairly doomed and its value would most probably suffer.

Apart from the fact that countries like China and other significant economies have a pragmatic interest in keeping some form of the Euro alive as an alternative to the US Dollar, there are other considerations in considering the Euro’s prospects.

A short term bullish scenario is that a deal will be struck this week that will keep Greece afloat and remove an immediate threat to the Eurozone . The Euro should strengthen against most other currencies in the short term. A longer term bullish scenario is that Greece will fail to meet the demands of staying in the Eurozone and will have to leave, perhaps by the end of this year. By this stage, it is conceivable that Germany will continue with the Euro on the assumption that it will subscribe to no more bailouts (as these are politically unacceptable to Germany’s voters and taxpayers) and that other weak countries like Portugal will exit. Again, this would be positive for the Euro in the longer term but after some currency turbulence in the interim.

All this apart, potential investors in the Euro will be keenly aware that many euroeconomies are going into recession which will put the Euro under pressure relative to the US Dollar but not necessarily against Sterling where recession is also a distinct possibility.

This week’s event could prove to be pivotal but it appears that the Euro may be in for a phase of relative strength as is already happening against the US Dollar. Against Sterling, the Euro has been trading around the €1.20 / £ level since early-January and, today, it is already showing some strength against the pound in Europe as shown below.

The US results season has yielded some strongly positive price reactions so far, particularly in the Financial sector, with Goldmans, Morgan Stanley and Bank of America (up between 7% to 11%) helping to push up market indices. However, shares are now attracting profittaking after a very good run. The S&P 500 has risen over by 13% since late-November and some constituent stocks have performed even better. A case in point is Apple Inc which gained 18% over the same period before being sold off last Thursday ahead of its first quarter results due on Tuesday. Some consolidation of the broader market is now beginning

to look imminent.

China is now ushering in the ‘Year of The Dragon’ which, given more accommodative action by the Central Bank such as the long-awaited cut in Reserve Ratio Requirement for banks, should prove to be suitably auspicious for investors. In our last strategy note, we highlighted the Shanghai Composite Index as poised to rally after several months of decline. Almost immediately, the index bottomed and, so far, has hung onto a gain of 8% over two weeks.

As the Chinese markets close for their New Year celebrations, the news flow is likely to be quieter for a few days.

SUMMARY

Summing up, the main points to catch the eye (and ears) are that the Euro may be on the edge of a rally if current developments pan out favourably. If Greece falls at today’s hurdle, more turmoil in the Eurozone can be expected for a few more months although, so far, the ECB chairman, Mario Draghi, appears to have been making some sensible, reassuring, moves. The S&P 500 is likely to find further progress harder going in the coming weeks although which of the possible threats to sentiment in the US will be responsible is not yet clear.

The recommendation to investors receiving this review is to adjust portfolios to take account of the changes in trends which have been flagged up here. This may involve taking some profits as appropriate to ensure liquidity is available for the next upleg.

Mike Franklin

Beaufort International Associates

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